March 18, 2010
Such explosive growth in debt can't go on forever, and it won't. Yet our current leaders and their apologists insist that the problem will magically solve itself.Paul Krugman ~ November 4, 2003
As Krugman explores the outcome(s) to China dumping U.S. assets further it is impossible to not acquire a sense of unease. Think about it: Krugman tells us (incorrectly) that interest rates are efficiently set by 'market expectations' and in the next line he claims that the Fed can set long-term interest rates to whatever level it wants. Which is it Krugman?
Rather than continue to attack Krugman with my words, why not do so with his own? Keep in mind when reading the quotes below that since 2003 the U.S. has grown more dependent on foreign capital, China has become the largest holder of U.S. debt, and the projected fiscal deficits for the U.S. have grown significantly larger.
"...the U.S. currently has very little leverage over China. Mr. Bush needs China's help to deal with North Korea -- another crisis that was allowed to fester while the administration focused on Iraq. Furthermore, purchases of Treasury bills by China's central bank are one of the main ways the U.S. finances its trade deficit.
Why did Krugman speculate about a 2-point jump in mortgage rates only 7-years ago while arguing that there would be no impact from a major Chinese reserve switch today?
"...we've developed an addiction to Chinese dollar purchases, and will suffer painful withdrawal symptoms when they come to an end." The Chinese Connection - March 20, 2005
Anyone care to speculate why Krugman now advocates a pain-free withdrawal from the U.S.'s addiction to Chinese dollar purchases?
"...there's no sign that anyone in the administration has faced up to an unpleasant reality: the U.S. economy has become dependent on low-interest loans from China and other foreign governments, and it's likely to have major problems when those loans are no longer forthcoming." The Chinese Connection - March 20, 2005
Again, why 'major problems' when China stops lending the U.S. money yesterday but no problems observed today?
Ignoring the contradictions, Krugman currently believes the following: the U.S. can attack China for manipulating its currency because the only blowback would be an advantageous (to the U.S.) devaluation of the U.S. dollar. Krugman also believes that even if China were to 'dump' its holdings long-term interest rates wouldn't rise because the Fed wouldn't allow this to happen.
Even if you agree with Krugman, it is obvious that this issue is not about currency prices and interest rates alone. An excellent summary of the U.S./China theme from Brookings recently explored this idea:
"But can China make a big difference to U.S. interest rates ...? The answer lies not in the absolute amounts of financing that China brings to the table, but in how its actions could serve as a trigger around which nervous market sentiments could coalesce."
What are some of the actions and their impact on market sentiment Brookings may be talking about? Consider a hypothetical: In response to the U.S.'s 25% surcharge China dumps Treasury Securities, enacts retaliatory tariffs against the U.S., invests $100 billion in Iran, and occupies Taiwan. As global stock prices crash and the Fed expands its Treasury purchase program by trillions, reports of a panicked move out of paper currencies and into precious metals abound. Thanks a lot new Krugman!
Embellishment aside, while focusing policy based upon the premise that the U.S. financial markets and U.S. dollar are too important to fail can, arguably, be beneficial to the U.S., this may only be the case if the policies adopted do not directly endanger the U.S.'s ability to borrow money at attractive rates of interest longer-term. In other words, before undertaking a risky protectionist experiment the U.S. would be well served to try and get its financial house in order (the Krugman of old would probably concur). The U.S. would also be well served to remember that there is ample reason to fear China so long as the U.S. is in pursuit of novel schemes to intentionally 'manipulate' the dollar lower...